I'm 60/40 equities/FI and looking for a conservative short-term investment grade bond fund to complete my bond allocation. I fall in the camp of taking risks on the equity side but want some diversification within FI. I initially thought about the Vanguard Short Term Index (BSV) but want a bit more duration with Treasuries and a bit less with Corporates. So, here's what I came up with:

I'm with Fidelity so it seems like the only two options are the Vanguard Short-Term Corporate Bond ETF VCSH (exp 0.12) or iShares 1-3 Year Credit Bond ETF CSJ (exp 0.20). It seems to me that CSJ is less risky than VCSH. But I haven't found much on these boards about CSJ. I'm wondering what your opinions are of these two ETFs and if there are any others worth considering (I don't have access to DFA)?

Postmon wrote:I'm 60/40 equities/FI and looking for a conservative short-term investment grade bond fund to complete my bond allocation. I fall in the camp of taking risks on the equity side but want some diversification within FI. I initially thought about the Vanguard Short Term Index (BSV) but want a bit more duration with Treasuries and a bit less with Corporates. So, here's what I came up with:

I'm with Fidelity so it seems like the only two options are the Vanguard Short-Term Corporate Bond ETF VCSH (exp 0.12) or iShares 1-3 Year Credit Bond ETF CSJ (exp 0.20). It seems to me that CSJ is less risky than VCSH. But I haven't found much on these boards about CSJ. I'm wondering what your opinions are of these two ETFs and if there are any others worth considering (I don't have access to DFA)?

The problem is most corporate bonds don't trade much-- illiquid. Either the issue sizes aren't big enough, or most of the investors just 'buy and hold'. It's therefore hard to build an index (or rather for anyone to accurately track that index in the real world), and hence an ETF. You get big bid offer spreads on the ETF and there's an inefficiency in the construction of the thing (one way around this, some ETF providers use, is to sign a 'swap' derivative contract with financial institutions, that guarantees the performance of the underlying index. My issue with that is that in a repeat of Lehman, we might find such swaps do not work as expected. ishares in particular tends to hold the actual underlying asset, not use swaps-- only close reading of the Prospectus and the Annual Reports will tell you what this ETF manager does).

For the mutual fund, as I understand it, VG gets around the problem by 'not indexing'. What they do is buy (and hold) corporate bonds of the right credit risk and maturity. They don't try to hold every bond nor the exact ones that are in the index. Also a lot of corporate bonds are callable, they pay higher yield but they are not nice for investors-- again I believe VG avoids bonds that may be called.

Therefore in this, as with many illliquid and slightly 'tricky' asset classes, I would prefer to own the Vanguard fund than an ETF.

VG fixed income are shrewd people, they've been doing this a long time. Probably DFA has as good people and approach, but I'd trust Vanguard on this one.

On your concern re duration I think the impact even on a big interest rate move will be marginal.

On credit quality I look at bonds down to A as essentially indistinguishable. I agree Vanguard has a somewhat higher weighting towards Baa, but 13.9% should not make a huge difference to final performance (one could test that by seeing how the 2 funds did in 2008-09).

On makeup 'supranationals' are things like Inter American Development Bank, IMF, World Bank etc. Backed collectively by the world's governments. They should be supersafe.

Also in an illiquid asset class, frequent contributions or redemptions kill performance for all unit holders. ETF managers can't do much about that, but again I trust Vanguard to restrict trading if that becomes a problem. They've done it before and, for example, they've closed (I believe) the High Yield Bond Fund to new investors.

I'd prefer a mutual fund as well having read about the pricing issues vs. NAV of corporate ETFs in stressful periods. However, the only one I was able to find is the Vanguard STIG fund, VFSTX. I'm with Fidelity so each purchase would cost $75 which is why I was looking at the ETFs. Since I'll probably only make one or two purchases a year, do you think it's worth going with VFSTX over an ETF given the $75 transaction cost?

Also, any concerns about going with IEI, the iShares Treasury ETF? The other option I was considering was to use both the short and intermediate Fidelity Treasury Funds to get to the 4.4 duration. But, I'd prefer to use just one fund or ETF, if possible.

No the problem is the underlying assets. Corporates don't tend to issue more than $1 maybe $2bn at a time. Then the buyers just buy and hold to maturity. Index composition into liquid issues that trade frequently is hard.

Contrast that to any particular US Treasury Bond. 10s of billions issued, trades every day. Easy to index.

I'd prefer a mutual fund as well having read about the pricing issues vs. NAV of corporate ETFs in stressful periods. However, the only one I was able to find is the Vanguard STIG fund, VFSTX. I'm with Fidelity so each purchase would cost $75 which is why I was looking at the ETFs. Since I'll probably only make one or two purchases a year, do you think it's worth going with VFSTX over an ETF given the $75 transaction cost?

It depends on the size of the purchases. I'd say if purchases are greater than $15k say (0.50%) it does not matter. Please take me with a grain of salt on this particular point as I have not thought about it a lot. Given that that loss is compounded (ie lost returns of say 3-4% pa), you could model it out until retirement-- see what it costs you.

Also, any concerns about going with IEI, the iShares Treasury ETF? The other option I was considering was to use both the short and intermediate Fidelity Treasury Funds to get to the 4.4 duration. But, I'd prefer to use just one fund or ETF, if possible.

No. The problems don't surface with an iShares on US Treasuries because the underlying asset is highly liquid.

To be honest, I doubt the differences between the 2 funds are so large. You would probably be OK with the CSJ fund if it is available to you at lower cost. The main risk with actively managed funds is that the managers normally reserve 20% for assets outset the prime purpose of the fund. That tends to be used to 'juice' the returns either by 1). going long on maturity to raise yield (and thus raising duration-- trouble if we rerun 1994) 2). going down in credit quality to raise yield (thus raising risk in a 2008 scenario) 3). doing something 'clever' with derivatives that leaves investors exposed in extreme market situations.

I trust VG not to do that- -they got their fingers burned having too many Worldcom and Telco bonds when that hit the fan in the early 2000s and I think they learned their lesson. Any other fund you have to take a view.